Over the last two years, many Fortune 500 (and similar-sized U.S.) companies have taken real action to better control their defined benefit (DB) pensions risk. This has been particularly noticeable in the area of freezing U.K. plans to future accruals. I have seen this first hand in almost every sector, including energy, consumer goods, pharma, tech and aerospace.
“One employer found that two-thirds of its U.K. pension spend was going on just 20% of its employees!”
After years of increasing and volatile costs plus additional layers of red tape, companies have made the decision to move to defined contribution (DC) benefits for all U.K. employees. These decisions have not been taken lightly – not least because they often affect thousands of employees at a time. However, the list of successfully executed freeze projects is ever increasing.
Despite the diverse industries in which organizations operate and the differing impacts on their businesses of the COVID-19 pandemic, there have been some common reasons for the decision to freeze DB plans:
01
With the average cost of DB accruals now likely to be over 50% of salary and reaching up to six times the maximum company contribution for many DC members, employers have felt compelled to take action to remove this inequity. One employer found that two-thirds of its U.K. pension spend was going on just 20% of its employees!
02
We have seen employers taking a global view of DB pension provision and undertaking a U.K. freeze at the same time as they freeze U.S. schemes. While freezes in the U.S. have often been implemented with a sunset period of five to 10 years, U.K. freezes tend to be implemented within much shorter timescales (from as little as three months’ notice). Some U.K. cases have, however, had a deferral period of up to two years and this deferral has introduced an opportunity to offer members an “early opt-out,” with take-up rates of such offers being high.
03
As most schemes closed to new hires many years ago, both the absolute number of employees in DB plans and the proportion of those employees in the overall U.K. workforce have decreased, accelerated by the large number of early retirements among older DB members and possibly triggered by the experiences of COVID-19. Assessing this profile has been a key consideration for employers and many have judged that the position has now evolved such that they can implement a freeze without any disruption to business — particularly important for those organizations with unionized employees.
04
While recent positive investment returns and reductions in life expectancy have been good news for most schemes’ funding positions, the resultant de-risking they have undertaken has led to further increases in the cost of DB pensions (even if these costs have not yet been captured by a valuation). We expect the U.K. Pensions Regulator’s strengthening of the funding regime later this year will accelerate this further. There are also many schemes that are now close to or at the point of removing all U.K. DB pension obligations from their balance sheets by transacting a buy-out. However, such a transaction cannot include future service benefits, so some employers have had to take proactive action to freeze accruals before they can fully wind up their U.K. scheme (and thus remove all associated risk).
“A freeze has been a timely prompt for many employers to review their existing DC plan.”
In addition to the more obvious benefits of reducing cost and risk as well as addressing equity issues, companies freezing their U.K. DB plans have found a number of other benefits:
01
A freeze has been a timely prompt for many employers to review their existing DC plan, which typically impacts a larger proportion of the U.K. workforce. Some have refreshed the contribution design for all employees, often increasing pension contributions and other ancillary benefits for existing DC members, partly with an eye on the emerging issue of pension adequacy. Others have leveraged the increase in DC plan membership to secure reduced charges for all members or improvements in the offering from their provider. In a number of cases, these improvements have been accessed through moving DC pension provision to a master trust arrangement — mirroring a broader trend of outsourcing DC provision in the U.K.
02
Another of the big trends we have seen is increased recognition of the importance of employee financial wellbeing. Some employers have taken the opportunity and cost savings arising from a freeze to review and improve their offering here. Again, and particularly given the current cost-of-living challenges in the U.K., this has been a welcome development for employees and has offset some of the adverse reaction to the freeze. The ability to focus on financial wellbeing has been further supported by the reduced amount of internal management time employers are spending on running a frozen plan.
03
While we are under no illusion that the implementation of a freeze is welcome news for members, one positive outcome companies proposing a freeze have experienced is increased member engagement in pensions. This has particularly been the case where the employer has provided a high level of support during the change process and has led to members taking more ownership of their retirement journey, as well as being more appreciative and aware of the benefits provided by their employer.
04
Typically generated from two areas: a curtailment gain and a longer amortisation period for accumulated actuarial losses, both feed directly through to the P&L. A curtailment gain arises from breaking the link to final pay, and it’s worth noting that the high inflation environment in the U.K. at the present time might represent an increased curtailment gain on a freeze. In addition, those employers who were amortising accumulated actuarial losses have found that they can be spread over the average expected lifetime of the members (normally around 18 years) rather than the future working lifetime (often around 10 years).
05
For a multi-employer arrangement (that is, a U.K. DB plan where more than one legal entity participates), as the number of active DB members reduces, the likelihood of involuntarily triggering a Section 75 (or “buy-out level”) debt increases. This can occur when a participating employer no longer has any active participants in the U.K. DB plan, at a time when at least one other employer continues to employ active members. The consequences of triggering such an event can require significant contributions from employers unless carefully managed. While a Section 75 debt event can still occur after a U.K. DB plan has been frozen, the triggers for it doing so are in the control of the employer.
So, if you have a U.K. DB plan still open to accruals and have not recently considered freezing it, we would suggest that now is the time to look into this. There are likely to be a number of reasons to move ahead, and you may find that a freeze has several other unexpected benefits.
